Written by Inflation is at 40 year high and the Fed just raised interest rates by three-quarters of a percent. The highest rate increase since 1994. Two questions many people are asking: (1) What is the impact of the fed rate hike and (2) how do we combat inflation?
You can’t change the seasons
If we were to talk about the seasons, you know we go from winter to spring, spring to summer, summer to fall, and then fall back to winter. There really isn’t anything we can do as far as the seasons are concerned to change this cycle. That that’s just the way it is. We have the same thing when it comes to the seasons or the cycle within an economy. An economy goes from growth to peak, peak to contraction, contraction to trough and back to growth.
You are always going to have the same order of seasons when you’re talking about gardening. You’re always gonna have the same order of seasons when you talk about the economy.
Impact of a strong economy
When you’re talking about inflation, we know that inflation has a few characteristics. One is there is a tremendous amount of growth and expansion. As a result, there is a high amount of demand for different products. When the demand is high, companies start raising their prices.
Anytime you have very low unemployment, what ultimately ends up happening on the job market? People’s wages start going up. Well, why is that? Because there are more jobs than there are people available. The only way a company can attract new talent is to pay people more than they’re making at their current job. After this happens a few times, a company is likely to raise the wages of all their employees. They don’t want to continue losing talent to the competition.
As wages increase, people are naturally going to spend more. This additional flow of money in the company impacts inflations in two ways.
Causes of inflation
First, the shelves are empty because everyone has more money. This is called demand-pull inflation. As companies continue running out of product, they start to raise their prices to match the new demand. On the other end, as companies continue to raise the wages of their employees, their costs continue to rise. The more money it costs a company to produce a product, the more likely the company is to raise their prices to cover the additional costs. This is called, cost-pull inflation. This type of inflation is caused by the costs rising. If we wanted to build a house and the cost of lumber increases, the cost of our house increases too.
Prices keep going up
Can you see why inflation usually accompanies times of high economic growth? This cycle continues until people decide the costs are too high to continue buying the products.
The problem is companies don’t like to quickly drop their prices. There simply is not enough certainty that the demand has changed. If a company lowers their rates and people start emptying the shelves again… it’s going to hard to raise prices again. Now, that is not the case with all companies. There are other companies that enjoy the additional profits. Those companies are not going to lower their prices for any reason. They’re generating more revenue and they have stockholders and their jobs to focus on.
Impact of the fed on inflation
What ends up happening is the government will step in and take on the task of lowering inflation. The Fed will lower inflation by making everything more expensive for everyone. They do this by raising interest rates. The Fed announced today they are going to raise interest rates by three quarters of a percent. Which is larger than you’ve seen any Fed raise interest rates since 1994.
The thought is, if they make it more expensive to buy houses, get loans and access money – demand will fall. As people have less money from the higher costs, they will purchase fewer goods. Which will force companies to bring their rates back down. The difficulty is knowing how much to increase interest rates. Their goal is to bring prices back down to pre-inflationary numbers. The Fed said they’re shooting for a 2% average inflation.
Danger of raising rates
That leads us to what is going to be the danger of raising the rates. Ideally, we just want to slow the demand down enough to bring prices back to where they were a year or two ago. The danger is if we raise the rates too much because the Fed misread the economic conditions, we could fall into a recession or even a depression. Then when the demand falls, companies will find themselves with a tough decision. What to do with their staff and their higher wages. Some companies will continue to operate as long as they can paying the higher wages. Others will give their employees the choice of lowering their rates and prepare for layoffs. Some companies will just start laying off their employees to balance their books.
Final thoughts
This is the discussion that takes place as the Fed continues to raise interest rates. Just as fall comes before winter, a peak comes before a recession. This is the dance that we are in to combat inflation. The Fed will continue to raise interest rates until inflation is under control.
Sources:
Corporate Finance Institute: Business Cycles
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